source [URL="http://in.rediff.com/getahead/2005/may/19shares.htm"]http://in.rediff.com/getahead/2005/may/19shares.htm[/URL]
What are bonus shares?
They are additional shares issues given without any cost to existing shareholders.
These shares are issued in a certain proportion to the existing holding. So, a 2 for 1 bonus would mean you get two additional shares -- free of cost -- for the one share you hold in the company.
If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you.
Who foots the bill?
You are right. There is no free lunch.
Bonus shares are issued by cashing in on the free reserves of the company. I mentioned earlier that the assets of a company also consists of cash reserves.
A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.
So you do not pay; and the company's profits are not impacted.
Will the price change after a bonus issue?
A bonus issue adds to the total number of shares in the market.
Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares.
This is referred to as a dilution in equity.
Now the earnings of the company will have to be divided by that many more shares.
Earnings Per Share = Net Profit/ Number of Shares
Since the profits remain the same but the number of shares has increased, the EPS will decline.
Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen.
That's because:
i. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.
ii. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future.
A bonus issue is taken as a sign of the good health of the company.
When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus.
After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus.